REITs as shock absorbers
Real estate trusts can add stability to a volatile portfolio, analysts say
NEW YORK (CNNfn) - Wall Street turbulence may cause motion sickness -- and one cure could be to head back to land.|
Financial analysts say portfolio owners looking for ways to mitigate risk and lock in greater stability may want to give real estate investment trusts (REITs) a closer look -- particularly after a period of volatility that has seen the once high-flying Nasdaq composite index retreat nearly 40 percent, then come back about 20 percent since January.
"Investors tend to focus on return and forget about risk, but as the markets have demonstrated recently, risk is very real and it's an important factor to consider when choosing between investment alternatives," said Todd Canter, a vice president with LaSalle Investment Management, a Baltimore-based real estate investment firm.
"From a standpoint of low valuations, high dividend yields and diversification benefits, I'd certainly look at REITs as a viable option," he said.
Better returns than utilities, Treasurys?
A REIT is a corporation or trust that uses the pooled capital of many investors to buy into either income property or mortgage loans. Such investment tools offer steady returns and hefty payouts, since they are required by law to distribute at least 95 percent of their earnings to shareholders each year.
It may help to think of REITs as you would a mutual fund, since they are essentially just a diversified portfolio of real estate investments under professional management.
According to the National Association of Real Estate Investment Trusts (NAREIT), Congress created the investment vehicles in 1960 to give small investors a shot at owning commercial real estate. Because REITs are traded like stocks on the major exchanges, however, they retain their liquidity.
They are also attractive because most are not required to pay corporate income tax to the Internal Revenue Service.
"You are seeing a lot of renewed interest in this sector from both retail and institutional investors alike," said Art Havener, a REIT analyst for A.G. Edwards & Sons. "Fundamentally, real estate is very strong in this country, but because REITs are designed to produce returns in the mid-teens, investors had been shying away from them in the last few years and going for tech stocks. There wasn't any appetite for REITs until now."
Between 1998 and 2000, the REIT sector tumbled 21 percent as get-rich-quick investors flocked to the tech sector seeking double and triple digit returns.
All that, however, is beginning to change.
Since the start of the year, REITs have returned 13 percent as demand for commercial property, including apartments and office buildings, continues to outweigh supply. That compares with year-to-date return for the S&P 500 index of less than 1 percent.
The tech sector in particular is up 2.9 percent for the year, according to S&P's sector scorecard.
At the same time, Goldman Sachs analyst David Kostin expects the REIT sector to soar another 15 percent during the next 12 months. That's substantially higher than the 10 percent growth rate for the overall equity market predicted by Kostin's more closely watched co-worker, Abby Joseph Cohen.
"The investment characteristics of real estate are that they have stable cash flows with income distributions in dividends and that can be attractive for anyone, young or old, seeking stability," Kostin said, noting the stability comes from long-term lease and rental agreements. "We expect growth to increase over the course of the year as cash flows continue to rise. They look reasonably favorable right now."
"If you look at most other indexes, everything is down so clearly REITs are benefiting this year, by default, because everything else is suffering," Havener said. "Volatility is good for REITs."
Diversification or bust
For investors, perhaps the greatest allure of the real estate investment trust is its dividend-producing potential -- territory that historically has been dominated by safety securities including utility stocks and Treasurys.
At present, REIT dividend yields are hovering at around 7.8 percent, Canter said. That compares to S&P 500 dividends of about 1.5 percent, Treasury yields that stand at about 6.5 percent, and utility stocks that currently pay out roughly 5 percent.
"Relative to other dividend producing vehicles, and certainly to the S&P 500, REITs are very attractive right now," Canter said.
According to NAREIT, the 198 REITs available to investors today boast a market capitalization of $129 billion. That's up from $11.7 billion just 10 years ago.
Most REITs are equity REITs, investing directly in income-producing properties. But there are also mortgage REITs that provide financing to property owners and a few so-called hybrid REITs do both.
Such investment tool, hit the skids in the 1998 when valuation levels reached a record low. But Canter said the sector is on the cusp of a comeback, noting REIT shares remain a good buy for investors.
The average ratio of price to funds from operations (FFO), the REIT equivalent to a price-to-earnings ratio, hovers near an all-time industry low of about 8 today. That's well below its multiple of about 14 just three years ago, and it's significantly lower than the P/E multiple of the S&P 500, which stands at around 26.
In its second annual study on the topic, Canter's LaSalle Investment Management firm found REITs were among the only investment securities with a negative correlation to certain large cap growth sectors including tech and communications.
In plain English, that means Canter and his colleague Keith Pauley quantified the risk reducing power of REITs, and found such instruments can reduce risk in a mixed-asset portfolio by up to 9 percent without sacrificing returns.
"We found that a portfolio consisting of 50 percent REITs and 50 percent tech stocks would have returned a higher risk-adjusted return than a portfolio of tech stocks alone," Canter said.
All are not created equal
For the individual looking to break into REITs, experts say it's tricky business. You'll have to pick your poison carefully.
"The days of buying a sector are over," Havener said. "You can't just plow money into the sector. Not all REITs are created equal. Investors have to be more discriminatory in where they park their money."
You'll also have to decide what your investment objectives are. Lower risk investment tools that have lower returns than other sectors, such as REITs, are generally preferred by older investors seeking to preserve the wealth they've acquired. But Kostin said REITs belong in the portfolio of anyone with an aversion to risk.
Havener noted that the best bets today are REITs that own properties in major metropolitan markets, particularly those on the West Coast and the Northeast.
"You should look for REITs that invest in offices and apartment complexes," he said, noting those categories are expected to outperform REITs that invest in industrial properties, hotels, health care and golf courses. "Clearly you want to be in California. That's a no-lose situation right now. If you are in California REITs you are looking good."
More specifically, Pauley said he expects solid returns from Avalonbay Communities (AVB: Research, Estimates), an apartment-focused REIT on the West Coast and Northeast, which is currently trading for about $40 per share. He also likes Vornado Realty Trust (VNO: Research, Estimates), a New York-based REIT with a diversified portfolio, and Boston Properties (BXP: Research, Estimates), which owns properties in the New York, San Francisco and Boston areas.
If you're not comfortable sifting through the price-FFO ratios, or weeding out the West Coast REITs from those based in the Midwest, you can always hire someone else to do it for you. There are plenty of REIT funds out there under professional management.
According to fund tracker Morningstar, SsgA Tuckerman Active has returned 16.43 percent so far this year. Security Capital U.S. stands at 15.68 percent and Phoenix-Seneca Real Estate brought in 15.47 percent.
(Click here for CNNfn's mutual fund coverage.)
"These are very predictable cash flow tools," Havener said. "They provide stable income streams and I think you'll see (more activity in the sector as) people gravitate away from risk."